Given the theatrics that is current US politics, it’s hard to recall a time when there was more anger and frustration towards America’s political and economic institutions than there is today.
However, if we cast our minds back to the 1970s, we encounter a time when energy shortages and oil prices were crippling many developed nations, and the US faced debilitating inflation rates and double-digit unemployment levels. The period has become known as the Great Inflation, with annual rates of inflation climbing to 13 per cent and beyond later in the decade.
The man brought in to solve these problems was Paul Volcker. Appointed as Fed Chairman by Democratic President Jimmy Carter in 1979, Volcker defeated inflation using a radical solution that saw interest rates soar to 20 per cent within two years.
His hard-line approach, which arguably led to the country’s recession in 1980, is viewed among many modern economists and political commentators as the tough but necessary measure that was needed to shock the economy back into place.
The problems caused by low inflation
Today, we face the opposite problem; inflation remains dangerously low across many advanced economies, despite the best efforts of central bankers worldwide. Given the challenges the world faces today, low inflation may seem like a benign issue to worry about, but in economic terms it is just as hazardous as the runaway rates of inflation with which Volcker had to contend.
Since Volcker’s battles with inflation, economic orthodoxy has gravitated to the idea that the best route to stabilise an economy is to aim for a specific inflation target, generally around 2 per cent in developed economies. However, for some time now, most developed economies have struggled to generate inflation rates anywhere near their central bank targets. Indeed, in Japan inflation is currently running at a rate of negative 0.5 per cent, while in Europe it is only 0.4 per cent, having dipped below zero several times in the past 3 years.
An inflation level that is persistently below its central bank target impacts economies in two key ways. Firstly, it increases the real burden of outstanding debt. Historical lending was done with future inflation expectations in mind. As such falling rates of inflation increase the real debt burden on borrowers. At a time when the governments in most advanced economies continue to run large deficits, despite already being heavily in debt, falling rates of inflation thus present a highly troubling development.
Secondly, zero bound rates of inflation greatly constrain central banks’ capacity to stimulate an economy in a future economic downturn. In simple terms nominal interest rates reflect two variables. The potential rate of growth an economy can support, and the current rate of inflation in that economy. Since the financial crisis, the underlying potential growth rate in most advanced economies has fallen greatly. If we add current anaemic levels of inflation to this lowered growth rate, the result is a dangerously low equilibrium interest rate for the economy. Dangerously low because the key policy tool central banks rely on to stimulate economies during downturns is their ability to cut (nominal) interest rates.
Over the past nine recessions the US Fed has had to cut interest rates by an average of 550 basis points to stabilise the economy and return it to growth. Today however, with advanced economies’ inflation rates stuck at 1 per cent or below, and underlying potential economic growth rates of 1 to 2 per cent at best, it takes considerable mental gymnastics to imagine a world where future nominal interest rates will rise much beyond 3 per cent.
Without a dramatic reboot in future inflation expectations then, it is reasonable to worry that central banks will no longer have the capacity to cut interest rates far enough in the face of future economic downturns. Central banks cannot meaningfully lower interest rates below zero, savers would no longer leave their savings at banks and a large part of today’s financial infrastructure is incapable of operating in a negative interest rate environment. Exacerbating this, financial markets are not blind to these risks. As central banks increasingly look powerless in their efforts to hit their inflation targets, so too will markets increasingly price in the risk of future calamitous central bank policy mistakes.
Given the dangers that chronically low inflation rates therefore present, is it right to wonder if central banking orthodoxy requires another Volcker to step forward?
Volcker’s vision
Volcker is currently held in high regard, but that wasn’t always the case. The economic cost of 20 per cent interest rates was high. As unemployment climbed past 10 per cent, he became one of the most polarising figures in US politics. Indebted farmers blockaded the Eccles Federal Reserve building in Washington with tractors and harvesters, while car dealerships sent coffins containing the keys of unsold cars to the Fed.
Meanwhile, Jimmy Carter failed to secure a second term as president and Republican Ronald Reagan entered the White House in 1980. Despite some of the strongest political protests in the Fed’s history, Reagan elected to renew Volcker’s tenure at the Fed.
By 1983, however, inflation had fallen to 3.7 per cent. Unemployment had peaked at 10.8 per cent in the previous year and was now steadily in decline. The recession broke and, despite immense political pressure, Volcker had survived to see the economy enter a sustained period of solid growth and low inflation.
Would a similarly radical approach work today? Since the 2008 global financial crisis, central banks in developed countries have pursued highly accommodative monetary policies, including record low interest rates and new policy tools such as quantitative easing (QE).
While their actions can largely be credited with preventing another Great Depression (no small feat), they have not yet been sufficient to break the cycle of chronically low inflation that the developed world suffers from today. The longer that central banks and governments appear powerless to generate the target rates of inflation that they set for themselves, the more entrenched lower future rates of inflation will become.
Political reluctance is one obvious problem; after nearly a decade of poor growth and austerity in some nations, there is little appetite among governments to steer their country down a recessionary path again. After all, while Volcker is revered, Jimmy Carter’s tough decisions, which arguably turned the economy around, potentially lost him a second term as president.
The road ahead
Given the inflation challenge that central bankers face, a number of radical new ideas have begun to surface in policy circles. The first of these is to significantly raise the inflation targeting level that central bankers have used since the Volcker era.
There are many challenges that come with a fixed inflation-targeting regime. One of the most well-known problems is that, at least in the short-term, central banks are usually only able to tackle either inflation or growth. This leaves them in an impossible position when faced with sudden supply shocks – such as a rapid rise in the price of oil, which might push growth too low and inflation too high. Further, a fixed inflation-targeting regime does not provide central banks with any flexibility to adjust for times when inflation has been historically high or low, such as the prolonged period of low inflation in which we find ourselves today.
Doubling (or more) inflation targets could help raise nominal interest rates to levels that are high enough so that central banks could deliver the necessary interest rate cuts to cope with the next recession, when it comes. Opponents however argue that changing long-held targets would undermine the hard won credibility central banks have earned over many years. This solution would also fail to counteract the issue of sudden supply shocks.
Abandoning inflation targets altogether is a more radical approach. But what other monetary policy could replace it? Targeting nominal GDP (NGDP) – the sum of all spending within an economy – is a possibility.
The total level of spending in an economy increases or decreases based on the sum of both the rate of inflation and the rate of economic growth. Setting out a future NGDP target would mean that central banks could let inflation fall when economic growth was strong, while introducing measures to stimulate inflation during financial downturns. Market participants would begin to anchor their expectations to a future level of NGDP, leaving central banks much more leeway in how they guided the economy to this point.
Under such a regime, borrowers and lenders would have more certainty in the future value of the loans they were engaging in, and central banks would not be tied to inflexible targets that left them unprepared when other economic factors were at play.
Yet, despite the potential benefits more unorthodox solutions may entail, central bankers have so far expressed little desire to put such ideas into action.
A world without inflation targets may seem like too big a leap for some, though it surely cannot be any more radical than a 20 per cent interest rate. Ultimately, if the inflation that economies need does not materialise soon, central banks will have little choice but to engage in more radical policy solutions.
Originally published by Cuffelinks